Rating agency multiplicity | FT Alphaville

Rating agency multiplicity

And so on, go the regulators.

But watch it. A new NBER working paper — by Bo Becker of Harvard Business School and Todd Milbourn from Washington University — asks just how increased competition affects the ratings industry? Their findings are not what you might expect.

To answer the title question, the two authors focus on how Moody’s and Standard & Poor’s responded to the rapid growth of then-upstart Fitch, in the corporate ratings space in the early 1990s. In other words, they look at how bond ratings changed — and subsequently performed — as Fitch’s market corporate bond rating share grew.

Their findings — in a nutshell:

The evidence we uncover appears unequivocally consistent with lower ratings quality as competition increased. First, ratings issued by S&P and Moody’s rose (moved closer to the top rating of AAA) as competition increased. Second, the ability of S&P’s and Moody’s ratings to explain bond yields decreased with competition. In other words, credit ratings are less informative about the value of bonds when raters face more competition. Third, the ability of firm level ratings to predict default is lower when Fitch has a higher market share (for data reasons, we use only S&P ratings for these tests). In one specification, speculative grade firms are 7.7 times as likely to default within three years as investment grade firms when competition is low (Fitch market share is at the 25th percentile), but only 2.2 times as likely when competition is high (market share at the 75th percentile).

Specifically, a one standard deviation increase in Fitch’s market share upped average bond ratings by between a tenth and half of a notch. Moving from the 25th to the 75th percentile of the authors’ competition measure reduced the correlation between ratings and bond yields — a measure of rating ‘accuracy’ — by about a third, and lowered the predictive power for defaults by two thirds.

How to explain the deterioration?

The authors aren’t entirely sure — but they tend towards this idea:

We conclude that competition most likely weakens reputational incentives for providing quality in the ratings industry, and thereby undermines quality. The reputational mechanism appears to work best at modest levels of competition.

The whole thing, as you might expect, ends with a caveat for regulators keen to increase competition amongst the industry. And while the focus of the research clearly isn’t structured products — upon which most of the recent ratings furore centres — you can see where the authors are going with this.

We should all just blame Fitch.

Related links:
IMF warns of ‘over-reliance’ on sovereign ratings
– FT
Why competition may not improve credit rating agencies – Bo Becker
Ratings agency scrutiny not just about CDOs anymore – FT Alphaville
The rating agency bailout – FT Alphaville